How Unicorns Grow

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Seven years ago Uber didn’t exist. Five years ago it was limited to San Francisco. Today it offers rides in more than 65 countries and at this writing is valued at more than $50 billion. Along the way the company has amassed an impressive war chest to fund its expansion and ward off competitors: It has raised more than $8 billion from private investors.

The meteoric rise of Uber and other “unicorns”—private, venture-backed companies valued at a billion dollars or more—feels unprecedented. But is it? And does that matter?

Research from Play Bigger, a Silicon Valley consultancy that works with VC-backed start-ups, confirms that they really are growing faster in recent years, at least as measured by market capitalization. It also examines whether raising lots of private capital prior to an IPO is an important determinant of future success and looks at the best time for these companies to go public.

The researchers began by exploring speed. They took the market capitalizations of 1,125 firms started in 2000 or later and divided each by the number of years since founding; the result is the “time to market cap.” A company founded five years ago that’s worth $2 billion, for example, has a greater time to market cap than a company founded 10 years ago that’s worth $3 billion. For firms that have gone public, market cap is the total value of outstanding shares; for private firms, it’s the valuation assigned by VCs during the most recent round of funding. (Private valuations are less precise, but they’re arguably the best approximation of value creation.)

The results were even more dramatic than the researchers expected. Firms founded from 2012 to 2015 had a time to market cap more than twice that of firms founded from 2000 to 2003. In other words, today’s start-ups are growing about twice as fast as those founded a decade ago.

Because the data doesn’t go back to the dot-com era, it’s not clear whether today’s start-ups are getting big more quickly than those of the 1990s. Some of the VCs with whom Play Bigger shared its research suggested that the data merely reflects a bubble. They believe that investors are overpaying for equity in unicorns, thereby inflating their market caps. In November the Financial Times reported that Fidelity Investments had written down its stake in Snapchat—reportedly valued at $15 billion at its last fund-raising, in May—by 25%. Also that month, the mobile payments company Square filed for its IPO at a price range that put the firm’s worth significantly below its private valuation, which was $6 billion in 2014.

Play Bigger founding partner Al Ramadan believes that although a bubble may be part of the explanation for today’s fast growth, fundamental forces are also at work. “Products and services get discovered and adopted at a speed never seen before,” he says. “Word of mouth today—through Facebook, Twitter, Tumblr, Pinterest, and so on—is just so fast, and it’s the most effective means of marketing.” Moreover, the launch of the iPhone, in 2007, not only opened up opportunities for products and services but also created a new way to rapidly distribute software, through the Apple and later the Android app stores.

“Get big fast” has been a start-up mantra since the 1990s. Many VCs try to grow their companies quickly in order to raise as much capital as possible; having a cash hoard, the thinking goes, gives a start-up greater flexibility and more power to fend off potential rivals. But another piece of Play Bigger’s research sounds a cautionary note in this regard.

“The More Money You Raise, the Less Value You Create”

Courtesy of Ryan Garber

Jim Goetz is a partner at Sequoia Capital, one of Silicon Valley’s oldest venture capital firms. He recently spoke with HBR about why start-ups are growing so quickly. Edited excerpts follow.

WhatsApp, which you funded, was sold to Facebook for $19 billion just five years after its founding. Is that growth indicative of changes in the market?WhatsApp spent almost nothing on marketing—word of mouth drove adoption. And today start-ups have the App Store and Google Play, which allow them to touch 3 billion consumers. For the first time in the mobile ecosystem, you can reach half the planet without building a distribution system. The size and scale of some new opportunities will reflect that.

If start-ups don’t need VC cash for marketing, should they be raising so much capital?In our portfolio there is a correlation between cash required and long-term market cap—but it’s negative. The more you raise, the less value you create. Google, Cisco, and Oracle were incredibly efficient with their cash, as were ServiceNow and Palo Alto Networks. Those companies all had market caps north of $10 billion within a couple of years of going public. One curse of raising lots of cash is you lose that discipline. We discourage our teams from raising too much capital.

What about Uber?Uber may be the counterexample. Expanding globally became an expensive proposition, so its war chest makes sense. Airbnb, in which we were an early investor, has also raised more capital than its cash flow statements and P&Ls suggest is needed, but for a different reason. Raising capital is attractive right now, and the company views it as insurance, not as something needed for operations.

Are we in a bubble?We don’t think so; we think private company valuations of some so-called unicorns have been inflated by the way late-stage investments were structured. In many cases investors are protected from much of the downside by terms that make the deal look more like debt than equity. If investors were unable to get those terms, they probably wouldn’t value some of the unicorns as highly. A handful or more of these companies may end up with Facebook-like valuations 10 years from now. But several dozen more will disappear.

Specifically, the researchers looked at the 69 U.S. companies in their sample that have raised venture capital since 2000 and subsequently gone public. They wanted to know whether the amount raised prior to IPO predicted growth in market cap after IPO—a proxy for long-term value creation. They found no relationship. “Candidly, we did not expect this result,” says Play Bigger founding partner Christopher Lochhead. “There’s a lot of belief in Silicon Valley that the amount raised really matters.”

If money raised doesn’t predict long-term value creation, what does? The research points to two interesting correlations. The first is the age of the company at IPO. “Companies that go public between the ages of six and 10 years generate 95% of all value created post-IPO,” Ramadan says.

It’s difficult to interpret the finding that company age at IPO predicts value creation, because companies today are not just getting big faster but also staying private longer. And it’s not clear whether the link between firm age and growth in market cap is causal. Are the strongest companies coincidentally all going public at about the same time? Or is there something intrinsic about companies that go public very early or very late that inhibits their ability to create value post-IPO? Play Bigger plans to explore the relationship in future research.

One possible interpretation of the IPO “window” is that many unicorns are missing their chance—staying private too long. Start-ups have been in no rush to go public, preferring to take advantage of plentiful private capital from hedge funds, mutual funds, and corporate VC firms. Public investors want to see some upside, so if unicorns remain private through too much of their growth phase, they may never conduct a successful IPO. And in some cases investors may wish they’d pushed companies to go public sooner, so as to realize returns while the firms were still growing rapidly. The privately held company Jawbone, for instance, founded in 1999 and once seen as a leader in wearable devices, has seen its market share decline and no longer ranks among the top five vendors in the category, according to the market research firm IDC. In November it announced that it was laying off 15% of its staff.

The researchers’ last finding is more qualitative. The group scored the companies in its sample on the basis of whether they were trying to create entirely new categories of products or services in order to fill needs that consumers hadn’t realized they had. They looked at whether firms are articulating new problems that can’t be solved by existing solutions and whether they are cultivating large and active developer ecosystems, among other criteria. They found that the vast majority of post-IPO value creation comes from companies they call “category kings,” which are carving out entirely new niches; think of Facebook, LinkedIn, and Tableau. Those niches are largely “winner take all”—the category kings capture 76% of the market.

“We hear all the time, Oh, this is going to be a huge market, room for lots of players,” says Lochhead. “But that’s actually not true.”

Tech start-ups are in a race to define new product categories, and the pace has quickened. Simply raising more money isn’t enough to win that race—and going public too soon or too late may limit long-term success. Even for unicorns, the path forward can be a challenge.